Price Indices and Inflation

  • CPI is a measure of the average change over time in the prices paid by consumers for a fixed market basket of goods and services.

  • It can be used to calculate the inflation rate.

  • Difference between deflation and disinflation:

  • Deflation: A decrease in the general price level of goods and services, which can lead to reduced consumer spending and economic stagnation.

  • Disinflation: A decrease in the rate of inflation, indicating that prices are still rising but at a slower pace.

  • Market basket = price times quantity for all goods in a given year

  • To calculate the market basket for a year that is not the base, multiply the new year’s price by the base year quantity

  • CPI = (Market basket of current year / market basket of base year) times 100

  • So inflation rate, or rate of change, = ((new -old) / old) times 100

  • Nominal vs. Real: nominal is referred to when variables have not been adjusted for inflation

  • If increase in % of nominal salary is lower than the percent of CPI , then the real purchasing power of an individual decreases, leading to a decline in their standard of living.

  • increase in CPI means inflation

  • Real value = Nominal Value / (price index / 100)

  • It shows the purchasing power of individual across time

Issues with CPI

  • Substitution bias:

  • Fixed basket: The Consumer Price Index (CPI) uses a fixed basket of goods and services, which does not account for changes in consumer behavior when prices change, leading to an overestimation of inflation.

  • Introduction of New goods: The CPI may not adequately reflect the impact of new products that enter the market, as the fixed basket does not adjust to include these innovations, potentially resulting in an understatement of the true improvements in consumer welfare.

  • Unmeasured quality Changes: The CPI may fail to capture improvements or declines in the quality of goods and services over time, as it does not adjust for these changes, which can distort the true inflation rate experienced by consumers.

  • Prices for some goods vary more than others

  • Many government programs use CPI to adjust for changes in the overall level of prices, so if social security gave $600 5 years ago, it would not go as far.